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Junk Status: How It Affects You, Sir. Yes, You.

23 May 2016

Note: this is an older 2016 version of this post. For the updated 2017 version, which takes into account S&P’s decision to downgrade South Africa’s sovereign debt, please click here: Junk Status: How It Affects You.

A question that I keep getting asked: “But how will a downgrade to junk status actually affect me? Quickly. Like, in two sentences. Thanks.”

So that’s a fairly tall order, because the answer is usually quite complex. But I’m going to try and work my way there.

Before you can talk about a credit rating downgrade, we need to talk about credit ratings in general.

What is a Credit Rating?

So a Credit Rating is an ‘independent’ assessment of the credit quality of a bond (or any debt instrument really), issued by a recognised credit rating agency.

When credit rating agencies first started, they were just investment research companies. They would do research on the various bonds in the market, publish their views in thick manuals, and then sell those manuals to fund managers and investors. For ease of reference, they applied letter grades to the bonds – with the A grades being good, and the subsequent letters, not so much.

[The] relationship between the rating agencies and the U.S. bond markets changed in 1936 when the Office of the Comptroller of the Currency prohibited banks from investing in “speculative investment securities,” as determined by “recognized rating manuals” (i.e., Moody’s, Poor’s, Standard, and Fitch). “Speculative” securities were bonds that were below “investment grade,” thereby forcing banks that invested in bonds to hold only those bonds that were rated highly (e.g., BBB or better on the S&P scale) by these four agencies [RA note: Standard, Poors, Moodys, Fitch – as they were at the time]. In effect, regulators had endowed third-party safety judgments with the force of law.

In the following decades, insurance regulators and then pension fund regulators followed with similar regulatory actions that forced their regulated financial institutions to heed the judgments of a handful of credit rating agencies.

[…]

In 1975, the Securities and Exchange Commission (SEC) issued new rules that crystallized the centrality of the rating agencies. To make capital requirements sensitive to the riskiness of broker-dealers’ bond portfolios, the SEC decided to use the ratings on those bonds as the indicators of risk.

Then people began worrying about the term ‘recognised rating manuals’ – because who’s to say what counts as ‘recognised’? I mean, if I pay you to give me a good credit rating, and then I alone choose to recognise it – is that enough to say that the rating is ‘recognised’?

More changes:

However, the SEC worried that references to “recognized rating manuals” were too vague and that a “bogus” rating firm might arise that would promise “AAA” ratings to those companies that would suitably reward it and “DDD” ratings to those that would not. If a broker-dealer claimed that those ratings were “recognized,” the SEC might have difficulties challenging this assertion.

To solve this problem, the SEC designated Moody’s, S&P, and Fitch as “Nationally Recognized Statistical Rating Organizations” (NRSROs). In effect, the SEC endorsed the ratings of NRSROs for the determination of the broker-dealers’ capital requirements. Other financial regulators soon followed suit and deemed the SEC-identified NRSROs as the relevant sources of the ratings required for evaluations of the bond portfolios of their regulated financial institutions.

And by today’s stage in the financial evolution, the rest of the world has echoed these policies in their own financial regulation. That is: we’re all collectively subject to the ratings agencies, because of fancy terms like “best practice”.

Some roll-out impacts:

Most of the world’s money is managed by large funds (pension funds, investment funds, medical aid funds, sovereign funds, etc).

Those funds are not free to just ‘make investments’.

They have to make investments in…um…”investment grade” securities. Not “speculative” ones.

And in Credit Rating Agency speak: “Speculative” = “junk”

What that means:

The standard story for credit ratings is: “the lower the credit rating, the higher the credit risk – and therefore, the higher the interest rate that the borrower will have to pay in order to compensate the lender for the extra risk”.

But because of this new and highly regulated defining line between “speculative grade” and “investment grade” securities, there is a bit of an ‘interest rate’ cliff floating around somewhere in the middle.

Here’s a Venn Diagram of the main problem:

So when a bond goes from being investment grade to speculative grade, there is a much-larger-than-usual impact because those bonds are now ineligible for most of the world’s investors. And those investors have to sell-out of their bond investments pretty quickly in order to be legally-compliant in their own jurisdictions, and you get this:

Apologies for my handwriting – that’s “cliff” not “cuff”.

When the “junk” downgrade happens…

So if South Africa were rated down to Junk status, there would be a sudden spike in interest rates. And even if there might be some anticipated sell-off in advance of a downgrade to junk, the real sell-off will still happen at and around the time of the actual downgrade.

This then has further ripple effects, because:

The ratings of corporate bonds of SA companies are linked to the ratings of the sovereign.

So if SA government debt is downgraded to junk, it’s incredibly likely that the parastatals, the SA banks, and everyone else will drop down to junk as well.

As investors are forced to divest from those bonds, you’ll then have them cashing in their Rands for Dollars and shipping their money offshore. So the Rand will plummet. And in expectation of this depreciation, you’ll no doubt find foreign investors in the JSE cashing out their equity holdings in order to try and realise their dollar-returns in advance of it.

Whether they’ll manage or not is a different question – but either way, whether expectation of a rand depreciation causes a rand depreciation and a sell-off in the stock market, or whether the sell-off in the stock market causes further rand depreciation, South Africa will still end up with a weaker stock market and a weaker rand.

To be fair, we really should be distinguishing here between:

Rand-denominated Government Bonds; and

Forex-denominated Government Bonds issued on the Eurobond market.

Rand-denominated Government Bonds are still quite strongly investment grade (because it’s not all that common to default on local debt – the government can theoretically arrange to have more Rands printed to repay that debt if it needed to). It’s the Forex-denominated Government debt that’s currently at risk.

But this is probably just a technicality. I know that there’s a difference between the two – now you might know that there’s a difference after reading this. But that will not be the general feeling. I almost challenge you to find me the ‘finance professional’ who still distinguishes between these two types of sovereign credit rating.

So putting that small side note aside, the rand depreciation means that there’ll inevitably be inflation. And the SARB will respond to that as it always does: by increasing interest rates.

As the costs of doing business and the costs of financing said business increase, corporate profits will decline, salary increases will slow, and the fiscus will come under pressure as its tax revenues decline. So there will be pressure on government to either increase taxes or cut back spending.

And if history is any indicator, given that it’s an election year…

What all the above means

The price of fuel will go up.

Your monthly mortgage repayment will go up.

Your monthly car repayment will go up.

The cost of coffee, olive oil, prosecco and all those imported fun things will go up.

The value of your pension savings will go down.

You almost certainly won’t get a bonus this year.

Annual salary increases will be small, if they happen at all.

You might even be retrenched.

And if you remain employed, it’s entirely likely that you’ll have to pay more tax.

Then if that’s not enough, expect more strikes as people get really unhappy about points 1 through 9.

And that situation will persist for some years. Unfortunately, once countries fall off the junk cliff, there’s a lot of self-fulfillment waiting at the bottom there. And climbing back up the cliff is arduous, and may require an IMF bailout.

So in two (very long) sentences:

“Junk status means that South Africa’s government, the parastatals, and South African corporates, will have lost access to much of the world’s investing money. Being cast out of the investment quality club means that: any first world comforts will be now be more expensive, anything financed with debt will cost more, the economy will stutter, jobs will be lost, and the South African taxpayers that are left will have to absorb the freshly-higher borrowing costs of the government’s debt – even as it might try to borrow more than before in order to keep up the levels of government spending that caused the cast-outedness in the first place.”

Gloom, eh? Let’s hope that I’m overstating it.

Also, fortunately, it never feels as bad as you’d expect. And I’m really not joking #ZimbabweanEmpiricism

Comments

Based on this, and the assumption that SA would be downgraded, is now the time to buy similarly rated bonds in other developing markets as the investors that will be required to sell SA bonds due to the downgrade will seek a similar risk bond in other developing countries to maintain their investment profile?

Thank you for this awesome post! If I may ask, what will happen when all the funds that can only hold investment grade securities need to sell off these assets? Who will be prepared to purchase them? Will they need to be written off by the funds? Will the debt issuer need to pay up and if so, will the Banks not face huge liquidity problems?

To answer your question: there are always investors willing to buy a security if the price is attractive enough. And that’s why the ‘interest rate’ goes up: as investors sell out, they’re forced to do so at lower and lower prices in order to find buyers. But the ‘coupon rate’ on a bond remains the same.

So let me give you an example of how that works. Let’s say that a bond has a face value of R100, and there’s a coupon rate of 5%. This means that the bond will pay out R5 per year until it matures (when the R100 gets repaid). If I buy the bond for R100, then the implied interest rate is 5% (that’s what I’m willing to earn) – and if the bond issuer wants to issue more debt, they’ll need to offer at least that kind of return (otherwise, I could just buy one of their other bonds).

But now let’s say I want to sell it, and I need to sell it in a hurry, and the only price I can get is R60. What does that mean? Well, the bond will still pay out R5 per year (the coupon rate), and I’ll eventually receive R100 at the end (hopefully, assuming that the bond doesn’t default). And let’s say that the bond is 4 years away from maturity. This all means that the effective interest rate on the bond is now actually 21% per annum. And more importantly, if the borrower wants to borrow more, they’ll have to pay 21% on any new bonds (because that’s already what the market is asking for).

Now a 21% return? That’s a pretty high return – and you’ll get high-risk hedge funds and private investors that are happy to take that risk.

So the liquidity problem is not really a question of write-offs – it’s a slower story of higher interest costs and a gradual cash flow squeeze each time the government or corporate tries to roll the debt (they borrow fresh debt to repay the old bonds). Because each time they go back to the market, they have to offer at least a similar rate to what the existing bonds are offering current investors.

Not so sure about #ZimbabweanEmpiricism – It really just depends on what Zimbabwe you’ve lived in. Things definitely have unfolded SIGNIFICANTLY differently for different people, mainly in consequence of different backgrounds – and those backgrounds? Well they’re something of a “throw of the dice”. At some of Zimbabwe’s worst points, the most pessimistic expectations understated the ultimate toll that the meltdown and atrocities took. Some of that is absolutely irresolvable too.